Price to Earnings (P/E) is a financial metric that measures the attractiveness of a company relative to its current earnings. Also known as price multiple or earnings multiple, the ratio indicates the price that an investor would be paying for $1 of a company’s earnings.
Value investors use the metric to determine if the stock of a company is overvalued or undervalued. The metric can also be used to compare a company’s current earnings with its historical record.
Price to Earnings Calculation
The price to earnings metric is calculated as a way of ascertaining whether the prevailing share price accurately represents the company’s projected earnings per share. The metric is calculated by simply dividing the market value per share and earnings per share.
P/E = Market value per share/ Earnings per share
There are basically two types of P/E
- Forward P/E
- Trailing P/E
Forward P/E is a type of price to earnings ratio that uses future earnings guidance instead of the most recent quarter. Often referred to as estimated price to earnings, the ratio seeks to compare the current earnings to future earnings. Value investors rely on a forward price to earnings metric to see what earnings could look like in the future.
One of the biggest drawbacks of forward P/E is that companies sometimes use the opportunity to underestimate earnings as a way of ensuring they beat analysts’ earnings estimates. Some companies overestimate their earnings as a way of getting a higher valuation in the market, then adjust it going into the earnings estimate.
Trailing Price To Earnings Ratio
The trailing Price to Earnings Ratio is a financial metric that provides a historical record of a company’s performance. The metric is calculated by dividing the current share price with the earnings over the past 12 months.
Unlike Forward P/E, this metric tends to be more popular as it is objective, given the use of actual numbers and not estimates. However it also has its fair share of drawbacks. For starters, past earnings might not act as a good indicator of how a company is likely to perform in the future, especially if there are changes in the market cycle and economic cycles.
In addition, value investors maintain that investors should invest capital based on companies’ future earnings power. The fact that earnings remain constant amidst fluctuating share price can also make the Trailing P/E unreliable.
Using P/E For Valuation
Professional investors rely on the P/E metric to assess the true value of a stock. The metric is an ideal tool for determining whether a company’s stock is overvalued, undervalued, or trading at fair value.
As a price multiple metric, the ratio indicates the amount of money investors would have to pay, per dollar of earnings. For instance, a stock trading with a P/E multiple of 15x means an investor must pay $15 for every $1 of current earnings.
A high price to earnings ratio relative to peers signals that a stock price is high relative to earnings, signalling overvalued conditions. A low P/E could signal a low stock price relative to earnings, indicating undervalued conditions.